Mission Concluding Statement 

Kosovë: Deklaratë përmbyllëse e misionit të nenit IV më 2018

October 30, 2018

An IMF mission, led by Stephanie Eble, visited Pristina during October 17-October 30 to conduct the 2018 Article IV consultation discussions. The IMF mission is grateful to the authorities and all other counterparts for their excellent cooperation, frank and open discussions, as well as hospitality.

Kosovo has continued to experience robust growth over the last year, maintaining fiscal discipline and strengthening financial sector resilience. However, fiscal risks have increased and should be carefully managed. Reforms to improve competitiveness and strengthen governance to achieve stronger and more inclusive growth, reduce unemployment and the large income gap with the rest of the Europe should continue to be on the forefront of the policy agenda.

Macro-economic developments and outlook

Growth is expected to be around 4.0 percent in 2018 , among the highest in the region, led by investment, consumption, and service exports, which in turn are underpinned by strong bank lending and remittance inflows. In 2019, growth is projected at 4.2 percent, supported largely by a temporary acceleration in public investment. Headline inflation remains subdued but has started to pick up because of higher food and energy prices and is expected to average 0.9 percent this and 1.4 percent next year.

The medium-term outlook remains favorable but subject to risks . Based on current policies, growth is projected to remain at around 4 percent and inflation to gradually converge to the European Union (EU) average. While growth could surprise to the upside if reform implementation accelerates, risks are tilted to the downside. Spending pressures, predominantly for higher, untargeted social benefit spending, if realized, would crowd out productive spending and likely increase the fiscal deficit. The proposed new power plant would provide an impulse to growth and reduce energy bottlenecks, but would also widen the current account deficit during the construction period and could—depending on its implementation—significantly increase public debt. Other domestic risks include political uncertainty that could undermine confidence and halt reforms. On the external side, a normalization of EU monetary policy or tighter global financial conditions could increase government financing risks in the domestic debt market. Weaker than expected growth in the EU could result in lower remittance inflows and decelerate growth.

Growth remains strong and macro-economic stability has continued, but important challenges lie ahead

Maintaining macroeconomic stability , managing fiscal risks, and advancing structural reforms are critical to ensure stronger and more inclusive growth . In particular, higher growth is needed to accelerate job creation and reduce the still large income gap with the rest of Europe. In this context, while there has been some progress, much needed structural reforms to tackle weak external competitiveness, low labor force participation and high unemployment, particularly among young workers, still lie ahead. In this regard, the mission discussed the following policy priorities:

Maintaining fiscal stability, containing fiscal risks and making efficient use of fiscal space

Multiple policy initiatives challenge the implementation of the 2019 budget, but the authorities are committed to address them. The 2018 budget deficit (under the fiscal rule definition) is expected to be around 1½ percent of GDP, well within the fiscal rule ceiling of 2 percent with lower revenue (including from local governments) and higher social spending offset by lower budget-financed investment. Importantly, the draft 2019 budget targets a deficit of 1.9 percent of GDP, keeps the wage bill constant as a share of GDP, and the bank balance at 4.5 percent of GDP, all in line with the fiscal rule. It accommodates increased allocations to priority sectors such as health, education, and the judiciary, but also higher (permanent) spending on pension benefits, relying on ambitious gains from revenue administration reforms (totaling about 1 percent of GDP, including ⅔ percent of GDP from additional tax debt collection and enforced compliance and ⅓ percent from local governments), as well as ¼ percent of GDP in savings from war veteran benefit reform. At the same time, the budget projects an acceleration in investment financed by donors and privatization receipts under the investment clause, which—if realized—would add an additional 4 percent of GDP in capital spending.

The “fiscal rule” remains an appropriate policy anchor from a fiscal stability and developmental perspective , but actions are required to offset spending pressures and risks . The mission advised to:

• Accelerate tax administration reforms to reduce informality, tax gaps, and tax debts . To meet the targets for tax debt collection and compliance gains foreseen in the 2019 budget, collections should be reinforced by setting quantitative and strategic performance targets, widening the tax filing requirements and late filing penalties, and improving the productivity of audits. Moreover, collection should be centralized in one office, the process systematized, and enforcement actions taken on a timely basis. Any changes to the import VAT collection system should retain collection with Customs and include proper safeguards (e.g., strict eligibility criteria, deferred payments secured by guarantee, rollout conditional on a successful pilot, etc.) to minimize any revenue risks. The granting of tax holidays or new exemptions that erode the tax base should be avoided.

• Move ahead with measures to contain spending pressures. This includes the long overdue reforms of war veteran and war disability benefits; and the restructuring of the publicly-owned enterprise sector, including by rationalizing employment and aligning wages with productivity. In this context, the mission advised against introducing unbudgeted non-contributory early retirement schemes for special groups (such as police), special benefits for teachers that worked during the 1990s, and universal child allowances as these would undermine the fairness and financial soundness of the social benefit system. Also, it is important that the wage bill ceilings remain anchored in the fiscal rule. In this regard, the public salary law should be reconsidered given its large fiscal costs, including the proliferation of discretionary allowances, and continued unequal pay because of grandfathering and exemptions to the new grid for special groups. Any pension increases should be limited to the basic pension to reduce the incidence of old age poverty and bring it closer to the social assistance benefit level. Following a sharp increase for the contributory pensions in 2016, any further increase would be ill-advised.

• Improve spending efficiency and outcomes. With increased budget allocations for priority sectors such as health, education and active labor market policies, efficiency-enhancing reforms in these sectors should move ahead in earnest to also improve outcomes. Despite some progress, the public investment framework requires further strengthening through better cost-benefit analysis and ex-post audits to maximize its growth impact. In this regard, the mission strongly advised to spread the use of privatization proceeds over multiple years--rather than frontloading the spending to 2019--and to limit the use of such funds to investment projects that have been carefully scrutinized for viability and return.

• Adopt contingency measures. The mission welcomed the authorities’ commitment in the draft budget to adjust spending in case of revenue shortfalls but strongly advised to execute the budget cautiously and to earmark specific non-priority spending (i.e., spending not allocated to priority sectors such as health, education, and infrastructure) that shall be cut in case of lower revenues or spending overruns in some categories. In particular, it advised the appropriations for these specific spending items to be released only once the additional revenue from tax debt collection and compliance gains foreseen in the budget have been realized, based on continuous monitoring and verification of those revenues.

To limit medium-term fiscal risks, the authorities should move carefully on initiatives that have long-term costs . In particular, plans to reform the first pillar pension and social benefit system should be part of a comprehensive plan to rationalize costly categorical benefit schemes, while strengthening social assistance for the poor. Moreover, the second pillar pension should be protected, and any changes to the first pillar carefully designed given large potential fiscal costs in the medium term. Any new initiatives for untargeted social transfers should be avoided. Also, while the planned power plant will help reduce energy bottlenecks, it must be financially viable. In this vein, tariffs should be set at cost recovery levels, and any government guarantees or financing should be within the fiscal rule limits and consistent with public debt sustainability to avoid crowding out other priority investments. More broadly, in view of competing spending pressures over the coming years, tax reforms could be considered in light of Kosovo’s still low tax rates by regional standards.

Financing should be diversified to reduce roll-over risks and avoid crowding out private sector credit. The mission welcomed further extension of debt maturities to reduce rollover risks. New instruments, such as retail or external bonds, pending market conditions and Kosovo’s progress in reducing country risk, could also be explored over the medium term, but any such move should be part of a comprehensive debt management strategy. At the same time, CBK’s holdings of government securities, purchased in the secondary market, should be gradually reduced, the bank balance of 4.5 percent of GDP maintained, and the exposure limits of the pension fund KPST respected.

Strengthening fiscal institutions and governance will also contribute to higher tax collection and spending efficiency and reduce corruption vulnerabilities . The mission welcomes the draft law on public enterprises that aims to improve financial oversight and accountability, as well as financial performance of the sector. Further, electronic procurement should be rolled out as envisaged, while the scope to further widen the coverage of centralized procurement assessed and capacity constraints addressed to ensure value-for-money.

Structural Reforms: Improving Investment Climate, Governance and Labor Market Outcomes

Reforms to reduce the very high levels of unemployment and inactivity should be at the forefront of the policy agenda . The mission welcomes the action plan to increase youth employment and recommends accelerating its implementation. Further, the authorities should focus on policies to promote labor force participation by, for example, further expanding affordable childcare and removing adverse labor market incentives in the design of social benefits. Several initiatives under consideration, however, such as the public salary law, excessive minimum wage increases, and generous maternity/parental benefits could work in the opposite direction by undermining women’s employability and excluding less skilled workers from the labor market. As such, the mission strongly advises against moving forward with these initiatives. While the new labor law under discussion would align the regulatory framework in many areas with international standards, the rules-based minimum wage setting mechanism established in 2013 should be swiftly reintroduced and provisions aimed at reducing informal employment be strengthened. Implementation of reforms to upgrade skills through better access and quality of education and vocational training should also be accelerated.

Better governance will also improve the business climate and help attract needed investment . Revenue administration and public procurement reforms should help level the playing field, while strengthening the “rule of law”, including in the areas of contract enforcement and property rights, will improve the business environment and facilitate access to cheaper financing. It will also be key to implement the law on licensing requirements and reduce administrative burdens to reduce the cost of doing business, and to move forward with the new law on risk-based inspections.

Safeguarding Financial System Stability and Financial Deepening

Kosovo’s banking sector remains well-capitalized, liquid and profitable, but supervisors should remain vigilant for possible pockets of risk. Banks’ non-performing loans, at 2.8 percent of total loans, are the lowest in the region. Nonetheless, the authorities should remain vigilant against the backdrop of continued robust credit growth and an easing of credit standards. In this environment, it is important to differentiate between healthy and excessive credit growth and apply prudential tools to mitigate risks as needed.

Further efforts to deepen financial intermediation should be carefully considered . While credit penetration at around 40 percent of GDP is low relative to other CESEE and Western Balkan countries, it has continued to increase, facilitated by low interest rates, KCGF guarantees of loans to SMEs, and strengthened contract enforcement. The CBK is working on regulation allowing for the creation of investment funds, while legislation regulating and widening the range of activities of micro-finance institutions (MFIs) is currently before parliament. However, these changes should be designed to ensure fair competition between MFIs and banks, while safeguarding prudential and consumer protection standards. The authorities should also continue to further reduce structural impediments to credit growth, including by fully implementing the law on enforcement procedures, accelerating the resolution of commercial cases (for example, by having more specialized judges and/or creating a commercial court), and strengthening property rights.

The mission welcomes the authorities’ request for a Financial Sector Stability Review (FSSR) by early 2019. With almost all 2012 FSAP recommendations implemented, this will provide a good opportunity to evaluate financial developments and inform the CBK’s new medium-term reform strategy and any planned legislative changes.